TYPES OF MARKET RISKS

The market risk can be broken down into different classes:

Interest Rate Risk 

This risk arises due to change in the yield curve. Since, interest dictates the returns and costs achieved in the business of lending and borrowing it affects not only current value of items of Balance Sheet of a financial institution but also the Off the Balance Sheet items. 

The various sources of interest rate risk are as follows: 

a) Yield Curve Risk: - This risk arises from shift in the fixed income securities due to change in the interest rate. This lead to change in the value of fixed income securities. Sometimes this loss may be so vital that the existence of any organization can also be at stake. 

b) Basis Risk: - Also called spread risk. This risk arises due to possible change in spreads. In the context of fixed income securities this risk arises due to change in relationship between interest rates based on different benchmarks. Suppose if a bank has lent money on PLR basis which is currently 10% and borrowed money on Repo basis which is 7%. Thus, it may be possible that due to change in interest rate of any basis this gap may be skewed. 

c) Repricing Risk: - This risk arises on reset date, and mainly affects the fixed income securities which are due for maturities or whose rates are to be reset at some time in near future. 

d) Optionality Risk: - This risk arises due to embedded optionality, feature in a financial product which gives either party (lender or borrower) an option to call or repay the money lent/borrowed. 

This option is normally exercised in case of change of interest rate to which the borrowed/lent amount is linked. Suppose current floating interest is 8% at which a person deposit money with bank for a period of 24 years. If after 6 months interest rate goes upto 9%, then if depositor has option to claim refund before due period, then certainly he will claim refund of fixed deposit so that he can reinvest the money at a better rate. 

This can also be possible from banks point of view, had the bank has option to refund money than if interest rate goes down then it can refund money already borrowed at higher rate and again borrow money at lower rate. 

Foreign Exchange Risk 

As discussed in the Paper of Strategic Financial Management, this arises on account of change in the price of foreign currency. Although it does not affect all financial institutions but mainly affects the organization involved in trading foreign exchange i.e. Buying and Selling forex or Institutions whose assets and liabilities are denominated in foreign exchange. 

Commodity Risk 

This risk mainly arises due to change in price of commodities, commodity prices index etc. This risk mainly affects those financial institutions whose main parties are supplier, consumers, and

traders of such commodities. A hedge fund which has invested a huge amount in and oil company’s share shall adversely affected by falling oil prices. 

Equity Risk 

This risk normally occurs when there is a fall in equity indices or most of the equity shares. This kind of risk normally results from any unprecedented events say sovereign default etc. In case if the Government of any country defaults in its debt repayment then its equity market is likely to be adversely affected.